Market participants can have a variety of legal competitive advantageous in public security markets. One of the more controversial ones is speed which is exploited by high-frequency traders (HFTs). Should the activities of latency arbitrageurs, such as HFTs, be curtailed or are they beneficial to markets? (For an explanation of how speed benefits latency arbitrageurs see my earlier post.)
There is general agreement that the ability to analyse investment opportunities better than others does not bestow an unfair advantage on an investor. As many resources as are desired can be spent to improve this ability. This might be, partly, because the participants who have outperformed and are outperforming are not typically those that have the most resources in terms of, say, the largest team of analysts or the most computing power. It might also be because there is widespread support for the idea that markets are efficient. It is therefore not possible to outperform public markets consistently and it is, therefore, a waste of effort to try.
Is it unfair, however, to allow market participants to have the advantage of speed? Any market agent currently has the right to invest as many resources as he wants to improve his speed. Is this not exactly how a free market system should operate?
Latency arbitrageurs outperform markets relative to market capitalisation weighted indices. As the market is a zero sum game with respect to these indices, this implies that the outperformance of latency arbitrageurs is to the detriment of all other market participants. In return for this, latency arbitrageurs would argue that they provide liquidity to financial markets. Is this correct?
For simplicity we assume that every market participant has access to all price-sensitive information and has the ability to calculate fair prices. Assets will then only be mispriced when savers need liquidity as explained in my earlier post. Liquidity providers participate because they can outperform by trading in the mispriced assets.
The liquidity providers would naturally compete to be first in the queue to exploit the mispriced assets. So they become latency arbitrageurs by definition. It can, therefore, be argued that the liquidity service provided by them is beneficial to savers and thus to the functioning of the market as a whole.
There is, however, one strong argument against giving latency arbitrageurs a free reign.
As discussed in an earlier post, allowing competition between traders based on the speed with which they (1) can obtain information, (2) calculate the fair price and then (3) trade, is likely to result in a small number of successful latency arbitrageurs. It could even result in a winner takes all situation − a monopoly. This is not seen as “fair” and desirable in a free market system.
We discuss in a following post how the “unfair’ advantage which latency arbitrageurs enjoy can be curtailed.